Buying Strategies
Part IV: Knowing When to sell
January 10, 2008
By Chandler Lutz
This is an extra bonus and fourth part to our three part series on buying strategies. Click here for the other parts.
The other articles in this series have dealt with how to buy a stock once you have found a great company and believe you are paying a fair price. So, it may seem counterintuitive that this buying strategy article deals with selling.
The idea of having an exit strategy was first explicitly developed by Mark Tier. Tier believes that an exit strategy is the most important investing habit an investor can practice.
To demonstrate the importance of an exit strategy let’s consider some extreme examples: The war in Iraq versus World War II. While World War II was raging on the American military began to plan the reconstruction of Germany and Japan before either country had surrendered. Once the War was finished, the American Military immediately facilitated the reconstruction in both of the enemy nations. The eventual economic success of West Germany and Japan validated the American efforts in those countries.
In contrast, the war in Iraq has developed in a much different way. The military developed a plan for Iraqi reconstruction under certain circumstances. If everything went according to plan, they knew exactly what they were going to do and how they were going to restore order and bring prosperity to the Iraqi people. This proved to be a large gamble in a volatile region with a culture very different than our own. Once things went differently than the military expected, they didn’t have a plan to deal with new challenges. They didn’t know how they were going to deal with IEDs, anti-American sentiment among some groups and growing terrorist strength and moral. They were forced develop solutions quickly and on the fly.
It is clear an exit strategy is important if you are conducting a large scale war, but it is also paramount for investors. After all, how are you ever going to bank the profits you work so hard to earn without knowing when to get out of your position? It is best to consider a plan to exit before hand and prior to high emotions induced by market folly that often sways your thinking. Also, a well planned exit strategy allows you to act decisively which eliminates the chance that you will fall victim to market subterfuge. The next obvious question is how to develop a successful exit strategy to avoid large mistakes.
The first part of developing an exit strategy is to determine how you expect the story to play out and what you are going to do if your predictions are correct. Are you going to sell once ABC Inc.’s new gizmo is a blockbuster success and the company is on the buy list of every major brokerage firm, or do you believe there are future growth prospects currently under development to further enhance your investment? In this case, an exit strategy ensures that you make the profits you thought possible when you bought the stock. The importance of this part of the exit strategy is obvious but cannot be understated.
In addition to determining your actions if the story plays out as you expect, you also need to clarify a course when events differ from those that you anticipate. If there is anything markets have taught us, it is that our investments often differ from our expectations. This is why we need to develop a comprehensive plan.
This step in the development of the exit strategy is just as important as the first, but it is the one most often overlooked by investors. It is this miscue which often leads to the largest losses.
The next step is to make a list of all the things that can go wrong and then what are you going to do if it happens. To quote Tier on the subject, “Don’t worry about what the market is going to do, worry about what you are going to do once it gets there.” What will you do if ABC’s new gizmo is a failure? How about if the market experiences a ten percent correction or an analyst downgrades the stock? What if the company cuts its dividend which attracted you to the stock in the first place?
At first this appears to endless process that could drive people to depression, but if you clearly define why you want buy the stock in the first place the workload decreases substantially. For example, if I want buy First BioTech Corp. solely because they have a new drug under FDA review I know exactly what I will do if the does not make it through the necessary trials: Sell! I may also want to consider what I will do if prominent analyst on CNBC spreads a rumor about the drug’s potential performance. Will I sell or ignore his “insight.” Also what will I do in the case of extensive insider buying or selling? If the insiders are selling, do I sell with them?
For every company the circumstances will change and so will your exit strategy. However, a well defined exit strategy with thought out contingencies for all scenarios will remove emotion from investing. Not only will this lead to lower stress (a great investment tactic according to most doctors), but it will also lead to higher returns.